ETFs vs Mutual Funds
Breaking down Exchange Traded Funds and Mutual Funds
Mutual funds have experienced rapid growth as a simple and secure form of investment in India. As of January 2025, the total AUM stood at INR 67.25 trillion. Compared to January 2015, when the figure was INR 11.81 trillion, there has been an almost sixfold growth over the past 10 years! Mutual funds have emerged as the de facto form of investing in India, particularly as SIPs (systematic investment plans) have grown rapidly.
So what is a mutual fund? Well it’s a relatively simple concept. Several people pool together their money and give it to a fund manager. The fund manager, an expert, buys certain stocks which he/she feels will perform well and give the participants in the fund the returns they are looking for. A mutual fund therefore involves stock-picking, with the fund manager using their expertise to choose specific stocks. Their goal is to build a portfolio which will outperform a benchmark index, the S&P 500 for example.
Sounds great right? It is. Mutual funds are simple and safe products. There are strict regulations on the liquidity management of the funds, and you can withdraw your money at any point in time. However, there are certain downsides. As the saying goes, past performance is no guarantee of future performance, and this is true for mutual funds - there is no guarantee that a fund that has beat the market in the past 5 years will continue to do so over the long-term. Additionally, there is enough academic evidence showing that consistently beating the market over the long-term is near-impossible, particularly when accounting for the higher fees charged by active funds1.
Realising that beating the market consistently in the long-run is near-impossible, asset managers came up with a new type of product - index funds2. The logic behind it was simple. If beating the market is impossible, then the safest and best possible returns can only be derived in one way - by becoming the market. That’s what an index is, it's a weighted average of all the publicly listed companies on the market.
At first, index funds were developed along the structure of a mutual fund. They were priced once a day (at the end of the trading day), according to their net asset value (NAV). The NAV is the sum of the value of all the assets owned by the fund, minus liabilities, and divided by the number of units of the fund sold to investors. However, realising that there was even more efficiencies to be found, in 1990 the Toronto 35 Index Participation Units was launched on the Toronto Stock Exchange. Three years later, State Street Global Investors launched the first major ETF, the S&P 500 Trust ETF, which remains among the largest ETFs to this day. ETFs differ from mutual funds in that they are traded throughout the day, with their market prices fluctuating like stocks depending on supply and demand. Investors can also use margin trading and stop-losses on ETFs, while they cannot do this for mutual funds. These factors make ETFs far more liquid and indeed responsive to market movements. Adding to their benefits over mutual funds, ETFs typically have lower expense ratios (the percentage of fees paid to the investment house for their services), and some don’t even have minimum investment amount requirements, making them far more accessible.
To conclude, ETFs took the idea of index mutual funds, and created a more liquid, cheaper, and more accessible product. Recent years have even witnessed the proliferation of active ETFs. These products create an index, actively picked by the fund manager, and create an index to mirror the performance of the underlying assets. The difference here is that while for an index ETF, the composition of the index is dictated by the market, for an active ETF the members of the index are being chosen with the goal of delivering higher returns. Similar to active mutual funds, active ETFs charge higher fees. While the development of active ETFs is certainly welcome, those who prefer passive investment may want to stick with index ETFs.
Carhart (1997). S&P also publishes a scorecard (SPIVA), benchmarking active fund managers performance versus indices. The 2024 results showed that in the 15-year period ending in December 2024, “there was no category in which a majority of active fund managers outperformed”.
John Bogle, the founder of Vanguard, launched the first index fund in 1976.